Monday, December 26, 2011

CLOs and the new bank capital rules

In the heyday of credit structuring the rating agencies had been far more successful in rating the securitizations of corporate debt than of mortgage debt. Collateralized Loan Obligations (CLO) tranches rated AAA had not lost principal during the 08-09 crisis (except for a couple of fraud cases), although often traded as low as 60-70 cents on the dollar because of uncertainties around corporate default rates. During the crisis banks like JPMorgan had bought significant amounts of the AAA tranches at large discounts and made enormous returns as the market began to realize that corporate defaults among leveraged companies will continue to stay subdued.

As a bit of background, between 2004 and 2007 CLO issuance had spiked tremendously as asset backed commercial paper (ABCP) issuance allowed banks to keep tranches in CP conduits and off their balance sheets using what used to be called "regulatory capital arbitrage". This allowed for ever larger leveraged buyout (LBO) transactions including firms like TXU and First Data.

CLO Issuance in $billion per year (source: LSTA)

As ABCP demand collapsed in late 2007 (driven primarily by concerns about subprime mortgages), CLO issuance collapsed as well.

ABCP outstanding (source: the Fed)

This year some CLO deals got done (about $13 bn) and the hope was that the business, in spite of being a fraction of pre-crisis levels, would continue to grow. But given the history of structured credit, the recent news that capital requirements will be increasing on AAA
CLO paper held by banks is not a surprise.

FT:
Under existing Basel rules, large banks using “internal-ratings based”
models are required to set aside just 0.56 per cent of the market value
of triple A rated CLO securities as capital against losses. That would
increase to a minimum of 1.6 per cent under the proposed US system, and
then jump to 8 per cent if cumulative losses on a CLO exceed 4 per cent.

Many new CLO deals have 25-30% subordination, making it nearly impossible to "pierce" the AAA, particularly given that most loans are senior secured corporate obligations. However over a few years most CLOs will accumulate losses of 4% or more - this is typical for a pool on non-investment grade loans. So the capital charge for holding the AAA tranche will suddenly become equivalent to holding some corporate loans directly. Yet these losses on the CLO will flow to the lower tranches, not the AAA. This new capital requirement will certainly make it capital inefficient to hold AAA paper on banks' balance sheets, particularly as it gets closer to maturity.

With CLO issuance in 2012 expected to be only slightly up from this year, the new regulation may significantly cut into this business. Banks tend to be the largest holders of the most senior tranches, making it almost impossible to structure a new CLO without a commitment from a large financial institution. In turn this will reduce demand for institutional loans (corporate loans of leveraged companies) that form the collateral pool for CLOs. When combining this regulation with new rules impacting the corporate bond market, funding costs for corporations, particularly the "middle market" (mid-sized) firms in the US will increase. This is yet another example of "unintended consequences" that some of the new regulation may introduce into the US economy.